Speech
Current Banking Issues

The Current Banking Scene

At this Conference a year ago I noted that the banking system was in pretty good
shape. This description is still apt, as the following indicators illustrate:

After-tax profits during 1995/96 increased to around 16 per cent of shareholders'
funds – a healthy enough return, when compared with inflation of 3 per
cent and a 10-year bond yield below 8 per cent.

Banks' average capital ratio, on a risk-weighted basis, is just over 11 per cent,
which is about one percentage point lower than a year ago but still comfortably
above the standard minimum of 8 per cent. In fact, the ratio for Tier 1 capital
alone is about 8 per cent. The average capital ratio for regional banks rose
over the year, to about 12 per cent, with the reduction in the overall ratio
due largely to a couple of overseas acquisitions and share buy-backs by major
banks.

Total bank credit growth has been 12 to 13 per cent - with the increases for housing,
other personal and business loans all close to this average.

Asset quality remains sound – the percentage of impaired assets in total assets
was about one per cent in June, compared with 1 per cent in the middle of 1995
and a peak of 6 per cent in the early 1990s. Loan write-offs were lower in
1995/96 than in the year before, while loans newly identified as impaired have
been steady (at around $0.8 billion) over recent quarters.

Banks have been able to maintain profitability even though their overall interest
margins declined again in 1995/96. In part, this was made possible by further
reductions in costs, with the ratio of operating expenses to income falling
slightly over the year.

Possibly the most interesting development in the past year was the outbreak of price
competition in mainstream home lending.

Competition in Home Lending

Beginning in 1994, the dominance of banks in the profitable housing loan market has
been strongly challenged by non-bank mortgage managers, funded mainly by the
issue of mortgage-backed securities to wholesale investors. They accounted
for about 9 per cent of all new housing loan approvals in the past year, up
from one per cent not long ago. (Life offices are also becoming more active
in home lending, but remain far less prominent than in the early 1960s when
they had a quarter of the market.)

The success of the mortgage originators has been due partly to the combined effects
of deregulation and low inflation – which have tended to raise the average
cost of banks' deposit funds relative to the market interest rates at which
the originators fund themselves. This narrowing of the banks' funding advantage,
together with their higher operating costs, left a large opening for the originators
to exploit.

As you know, the banks first tried to meet this new competition with special offers
aimed only at new customers, including:

By mid 1996, however, banks were forced to reduce their standard variable rate, for
new and existing customers, as borrowers became more willing to ‘shop
around’ and banks' market share continued to erode.

Since then, the spread between banks' standard variable housing rate and short-term
money market rates has fallen to around 2 per cent, compared to 4 per cent
only a couple of years ago. The latest declines in housing rates have not yet
reflected in the data on banks' overall margins, and virtually guarantee that
these will fall further in 1996/97.

What are the likely effects on profitability? We estimate that, on an ‘other
things equal’ basis, the decline so far in housing margins could reduce
the major banks' return on equity by about one percentage point. For regionals,
which do relatively more home lending, the impact might be about 3 percentage
points. The actual net impact on profits will, of course, vary from bank to
bank, and will depend on what other changes occur in fees, costs and so on.
We will no doubt see:

more strenuous efforts to recover directly the cost of transactions and other services
and unwind the cross-subsidisation of these services from interest margins.
So far, banks have not made much progress in raising the overall proportion
of their income gathered in fees and charges;

increased resort to alternative methods of distribution, such as mobile lenders,
telephone banking and the Internet. Moves in these directions have already
been made by many banks;

continuing pressure to cut operating expenses, especially through closing and reconfiguring
branches. Banks will also, however, have to commit large sums on investment
in new technology.

Regional banks will also probably intensify efforts to reduce their reliance on housing
by diversifying into commercial and other personal lending. Aggregate statistics
indicate that, so far, little progress has been made in this direction although,
again, the picture varies from bank to bank. Interestingly, some regionals
seem to have been more successful in diversifying their exposures geographically,
lifting significantly the proportion of home lending sourced outside their
home state.

I note that the more competitive housing market seems to have gone with some weakening
in the quality of loan portfolios, but the extent does not give rise to prudential
supervision concerns. Banks' housing loans past due by 90 days or more are
now almost double their level at the beginning of 1995. However, such loans
still represent less than one per cent of total housing portfolios.

An intriguing question is whether housing margins will fall further. In speculating
about this, it might be relevant that the margin between banks' standard housing
and short-term funding rates in Australia is still higher than comparable spreads
in other countries.

Innovations in Finance

Events in the home lending market are an example of specialist entrants competing
for a particular line of bank business. An earlier example was the cash management
trusts. We are likely to see more of this as new technology makes possible
alternative distribution channels which can displace banks' branch networks
as points of contact with customers, and as low inflation continues to reduce
the relative advantage to banks of their low-cost deposits. In addition, the
funds management sector will continue to grow in relative importance, as a
result of government policies to encourage retirement saving and the community's
desire to diversify its financial wealth. This will raise the demand for securities
for investment portfolios, creating opportunities for the banks to securitise
the more standard loans on their balance sheets, but also making it easier
for some financing to by-pass them altogether.

These trends clearly pose significant commercial challenges to the banks. They call
for responses along the lines of those we are seeing in the housing market
and in the payments system where banks are establishing alliances with software
and communications specialists.

The more nimble the banks are in these areas, the more successfully they will maintain
their current positions of dominance in most markets. The capacity of Australian
banks to respond to innovation and competition is often understated. They have
been relatively quick to adopt new technology and their customers are relatively
sophisticated users. Either in their own right or through subsidiaries, banks
can undertake virtually any form of financial activity – funds management,
securitisation, underwriting, life insurance and so on. The main supervisory
conditions are that customers understand clearly what sort of product they
are purchasing, and that activities outside the bank proper do not put at risk
the capital supporting depositors' funds.

The Wallis Inquiry will have to decide what the emergence of new competitors like
the mortgage originators means for supervision and regulation. This will require
separating the genuine public policy issues from the hyperbole of some established
players.

It seems clear enough that the entry, or potential entry, of new players in banking
markets should be taken into account in assessing the intensity of competition
and considering proposals for mergers and acquisitions.

It is much less clear that these innovations have major implications for prudential
supervision. As we outlined in our submission to the Inquiry, banks are supervised
more closely than other financial institutions not only because they remain
the biggest group in the system, but because the bundle of activities they
undertake makes their health particularly important to the robustness of economic
activity and, conversely, because serious weaknesses among banks can pose a
threat to broader economic and financial stability.

Banks are more vulnerable than other institutions to loss of depositor confidence
because their liabilities are relatively short-term and fixed in value, while
their assets are mainly long-term and difficult to value. A run on one bank
can become contagious. Banks are the main lenders to small and medium commercial
borrowers who do not have direct access to capital markets and who have difficulty
getting alternative funding quickly if their normal source dries up. Finally,
banks have extensive linkages with each other – both through the payments
system and financial market trading – so that a problem in one can spread
quickly. (The introduction of real-time gross settlement for high-value electronic
payments will substantially reduce, but not eliminate, interbank payment risk.)

This is familiar ground. The important point is that, despite the innovations occurring
in financial markets, banks remain ‘special’ in having this bundle
of functions and will continue to warrant particular supervisory attention
as a result. In countries like the United States, where the banking sector
is a much smaller proportion of the financial system than in Australia, special
importance is still attached to its supervision.

These issues are explored more thoroughly in the RBA's Submission to the Wallis Inquiry
and in our recent publication, ‘The Future of the Financial System’.

Prudential Supervision Issues

I would like now to comment on two current developments in bank supervision policy.

Tripartite arrangements with external auditors

In consultation with banks and their external auditors, we've been seeking to improve
the longstanding arrangements under which the auditors give us independent
assurances about the effectiveness of banks' management systems for monitoring
and controlling risks. For some time, we've felt that the auditors' views on
the adequacy of banks' systems gave little useful guidance to potential problems.

Under new arrangements, which come into effect very soon, each bank's chief executive
will be required to provide us annually with a declaration, endorsed by his
or her board, stating that management has:

…identified the key risks facing the bank, has established systems
to monitor and manage those risks including, where appropriate, by setting
and requiring adherence to a series of prudent limits and by adequate and timely
reporting processes; that these risk management systems are operating effectively
and are adequate having regard to the risks they are designed to control; and
that the description of systems held by the Reserve Bank are accurate and current.

We expect that these declarations, which are due within three months of the end of
each bank's financial year, will help focus the attention of boards on their
responsibilities for clearly articulating a bank's appetite for risk and then
for ensuring that the appropriate framework of risk management is in place.
The first declaration will be provided by those banks whose financial year
ends this month.

The second new element is that external auditor reports to the RBA will in future
concentrate on the scope and effectiveness of systems in particular areas of
a bank's operations, rather than offering a general view on a range of systems.
The subjects of these targeted reviews will be selected at the annual meeting
between each bank, its auditors and the RBA around the end of the bank's financial
year, with the relevant report submitted in time for assessment before our
next tripartite meeting.

Market risk and capital adequacy

In August, we sent banks copies of a draft Prudential Statement on capital adequacy
guidelines in relation to market risk. This is modelled closely on the international
guidelines issued by the Basle Committee on Banking Supervision in January
this year and extends the existing capital framework to capture the risks associated
with banks' trading activities – that is, the risk of losses from movements
in interest rates, exchange rates, equity prices and commodity prices.

In calculating capital requirements for market risk, banks will have the choice of
two methods:

the ‘standard measurement’ approach, or

their own internal risk management models, subject to these satisfying several qualitative
and quantitative criteria.

The decision to allow the use of in-house models to measure risk is a significant
departure from past supervisory methods. It recognises the shortcomings of
more prescriptive standard approaches in areas which are characterised by ongoing
innovation and where some banks already employ sophisticated risk management
models tailored to their own operations.

Under the Basle guidelines, national supervisors have discretion in several areas
in applying the new arrangements. We have used this in deciding not to accept
term subordinated debt with maturities as short as two years as eligible capital
– ‘Tier 3 capital’ – even with ‘lock-in’
conditions to prevent repayment if this would leave capital ratios below the
required minimum. We remain unconvinced that such debt has the features required
of capital, and we have doubts about the practicality of the lock-in conditions.

Consequently, it is difficult to justify the additional complexity which Tier 3 capital
instruments would bring to measuring capital ratios. Moreover, it is uncertain
how attractive Tier 3 instruments will be to investors.

If, in the future, it seemed that Australian banks were being competitively disadvantaged
by their lack of access to the additional tier of capital we would be prepared
to review our position.

We've asked for final comments on the draft Prudential Statement by the end of this
month, and intend to introduce the new framework at the end of 1997. Individual
banks may seek earlier implementation.

While the market risk guidelines represent an important and desirable extension of
the capital adequacy framework, their impact on Australian banks seems likely
to be small.

No bank has indicated a need to raise additional capital as a result of the market
risk guidelines. This is not surprising given the existing excess of capital
over current requirements and the small additional amounts of capital likely
to be required by most banks to cover their market risks. In fact, because
existing credit risk charges will be replaced by lower ‘specific’
risk charges for interest rate and equity products, it's possible that some
banks could actually need less regulatory capital under the new guidelines.
(Macquarie Bank, for example, in its 1996 Annual Report suggested that it would
have been in this position had the new guidelines been operative.)

We are now into our second round of on-site visits to review banks' systems for managing
market risk. These visits, which complement the parallel program looking at
management of credit risk, focus on the internal control mechanisms used by
banks in their trading activities, including in relation to derivatives.

Our judgment is that the risk measurement methodologies used by the Australian banks
with major treasury operations are relatively advanced by international standards
– although this does not mean there is no room for improvement. Also,
we would like to see more stress testing to assess how management systems would
cope with unexpected but possible shocks in market conditions.

Directions in Bank Supervision

The two policy developments I've touched on illustrate the trend for supervisors
to put more reliance on banks' own management systems, and to emphasise that
the primary responsibility for their sound operation lies with their boards
and senior management. This thrust, which is endorsed in submissions to the
Wallis Inquiry by several banks, is consistent with trying to avoid the inefficiencies
and costs which more prescriptive styles of supervision can entail. It also
recognises that for banks engaged in extensive market activities – where
exposure positions can change quickly – the quality of internal management
systems is a key defence against large losses. This message has been driven
home by the recent problems of Barings, Daiwa and Sumitomo. Supervisory monitoring
of historical capital positions, on its own, is not enough.

Bank supervisors are also expecting banks to improve the quality of information disclosed
publicly. This helps the market professionals to exercise their own disciplines
on banks, as a complement to supervision. We have, for instance, been encouraging
banks to upgrade information on asset quality and off-balance sheet activities,
particularly derivatives, and it has been gratifying to see a marked increase
in the volume of useful information published in the past year.

It's been argued in certain quarters that the greater complexity in some areas of
banking renders prudential supervision ineffectual, and that it should eventually
be replaced by a disclosure regime where depositors and investors have to make
their own judgments about the soundness of banks. I think this misses the point
that greater complexity and more rapid change in the business of many banks
severely limits the extent to which a public disclosure regime could realistically
substitute for official supervision, with all its limitations. The public has
neither the time nor the expertise to make continuous informed assessments
of banks.

It is also more than a little naive to suggest that disclosure-based regimes can
do away with community expectations that the Government will have to take a
close interest in resolving any threats to the health of the banking system.

End Piece

I hope that these comments have been a useful scene-setter for the discussions to
follow over the next two days, and I wish the rest of the Conference well.